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OK. So do you go all-in, or throw in the towel? That’s the question that most holders of PSS will be thinking today. Though it’s not in our portfolio, this is definitely a name I’ve liked, and have been warming towards recently, so I am definitely in the same camp. Here’s a few notables…
Reasons to consider throwing in the towel
1) PSS missed both the Street’s and my estimate (-$0.44, and -$0.36, respectively) by a mile. Losing $0.54 with such negative momentum is not exactly indicative of being one of the ‘winners’ in this climate.

2) It’s been over a year since the Stride Rite acquisition, and over 2-years since this management team hit stride in its strategy to regain control of the consumer and grow the business. At some point sooner than later, we need to draw a line in the sand and expect results.

3) ‘Consumer connection’ has never been higher per Payless’ internal scoring system, but what good is that if we’re not seeing it in numbers?

4) Costs out of China are higher than the company guided, though this is not a big surprise to us.

5) Due to promotional environment & inventory levels at competitors, higher cost shoes were discounted so heavily that they impacted sales at PSS’s “primary” brands.

Reasons to keep the faith
1) Price point is up, transactions are up, product mix is improving, customer scores are reportedly getting better. Weak traffic is the problem. If there was ever an environment to give a zero-square-footage-growth retailer the free pass on traffic, then this is probably it.

2) Very interesting to hear Rubell say that he’s never seen inventory more healthy. Inventory in dollars ended the quarter up mid single digits, but in units it was down single digits. Setting the stage for better gross margins in 2Q onward?

3) SG&A cost reductions better than expected ~$30mm of identified reductions in 2009 with more possible. We’re modeling SG&A down 3-4% in absolute dollars in 2009.

4) Sperry and Saucony continued double digit growth rates with category growth for Sperry and channel expansion for Saucony (Europe) promising.

5) Significant CapEx reduction (from $130 to $85) will boost FCF. Even with operating cash flow down by a third, FCF growth should still be positive for the year.

6) THIS COMPANY IS NOT GOING BANKRUPT, AND WE DON’T EVEN THINK THEY’LL COME REMOTELY CLOSE TO BREACHING A COVENANT.

7) How I’m doing the math, the cash flow here should get total net debt down by 80% over the next three years. What does that mean? It means that today the EV/EBITDA multiple of 3.8x is nothing to write home about on the long side. But with debt coming down, we’re at 1.5-2.0x EBITDA 2-3 years out. At that point, we’re also looking at about 4x EPS. I’ll take that.

8) Timing considerations… In 2H, we see costs from China come down, duplicative DC costs come off, SG&A cuts, lower interest expense and tax rate, all at the same time we cycle very easy top line compares. When I put this in context of my view that cash flow for the group overall will begin to turn in 2Q/3Q (see my 3/5 note I’m Getting Fundamentally Bullish), and it starts to paint a nice multiple-expanding picture for PSS.

I’m definitely not throwing in the towel here. In fact, expect me to synch more with Keith on this one as it relates to his timing and sizing models for a potentially powerful long-term call.

Casey Flavin
Brian McGough